The global credit crisis has led not only to the first worldwide recession since the 1930s, but also left an enormous burden of debt that now weighs on the prospects for recovery. Today, government and business leaders are facing the twin questions of how to prevent similar crises in the future and how to guide their economies through the looming and lengthy process of debt reduction, or deleveraging. To help address these questions, we will now look into Ray Dalio's article "An In-Depth Look at Deleveragings" on the subject. Ray Dalio manages the Bridgewater Pure Alpha fund, which earned its investors $13.8 billion in 2011, taking its total gains since it opened in 1975 to $35.8 billion.
Deleveraging - Sometimes beautiful and sometimes ugly
Deleveraging happens when the debt burden becomes too large to manage, and the process involves reduction of debt/income ratios. Historical anecdotes show some deleveraging to be well-managed and some involving a painful process.
- Ugly deleveraging is characterized by great economic pain, which could be in the form of social upheaval and sometimes wars, while failing to bring down the debt/income ratio.
- The beautiful ones are those with orderly adjustments to healthy production-consumption balances in debt/income ratios.
How are the deleveraging issues resolved? The differences between how this deleveraging challenge is resolved depend on the amounts and paces of: 1. Debt reduction, 2. Austerity, 3. Transferring wealth from the haves to the have-nots and 4. Debt monetization.
What are its different effects on inflation and growth?
- Debt reduction (defaults and restructurings) and austerity are both deflationary and depressing
- Debt monetization is inflationary and stimulative.
Ugly deleveraging gets these out of balance while beautiful ones properly balance them. In other words, the key is in getting the mix right. Typically, in response to a debt crisis, these four steps takes place in the following order:
Phase 1) Ugly deflationary deleveraging: At first, problems servicing debt and the associated fall off in debt growth cause an economic contraction in which the debt/income ratios rise at the same time as economic activity and financial asset prices fall.
- Characterized by debt reduction (defaults and restructurings) and austerity without material debt monetization
- Fall in private sector credit growth and the tightness of liquidity, which lead to fall in demand for goods, services and financial assets.
- Financial bubbles could burst when there is not enough money to service the debt, and debt defaults, Restructurings hit people, especially leveraged lenders (banks), like an avalanche.
The fear could turn into a serious liquidity crisis, which the policy makers strive to contain before it spins out of control. Defaults and restructurings cannot be too large or too fast, because one man's debts are another man's assets, so the wealth effect of cutting the value of these assets aggressively can be devastating on the demands for goods, services and investment assets.
Policy makers could also resort to austerity measures (reduced spending), as it becomes difficult for the debtor to borrow more. The problem is that one man's spending is another man's income, so when spending is cut, incomes are also cut, so it takes an awful lot of painful spending cuts to make significant reductions to debt/income ratios. Normally, policy makers play around with this path for a couple of years, get burned by the results, and eventually realize that more must be done, because the deflationary and depressing effects of both debt reduction and austerity are too painful. That leads them to go to the next phase in which "printing money" plays a bigger role. This does not mean that debt reductions and austerity don't play beneficial roles in the deleveraging process, because they do - just not big enough roles to make much of a difference and with too painful results unless balanced with "printing money/monetization".
Phase 2) Beautiful deleveraging: In the second phase of the typical deleveraging the debt/income ratios decline at the same time as economic activity and financial asset prices improve.
- Characterized by enough "printing of money/debt monetization" to bring the nominal growth rate above the nominal interest rate and a currency devaluation to offset the deflationary forces
- Central banks provide adequate liquidity and credit support for key entities' need for capital
This produces relief and, if done in the right amounts, allows a deleveraging to occur with positive growth. The right amounts are those that a) neutralize what would otherwise be a deflationary credit market collapse and b) get the nominal growth rate marginally above the nominal interest rate to tolerably spread out the deleveraging process. At such times of reflation, there is typically currency weakness, especially against gold, but this will not produce unacceptably high inflation, because the reflation is simply negating the deflation.
History has shown that those who have done it quickly and well (like the US in 2008/09) have derived much better results than those who did it late (like the US in 1930-33). However, there is such a thing as abusive use of stimulants. Because stimulants work so well relative to the alternatives, there is a real risk that they can be abused, causing an "ugly inflationary deleveraging".
Phase 3) ugly inflationary deleveraging: This phase occurs when there is too much "printing of money/monetization" and too severe a currency devaluation (which are reflationary) relative to the amounts of the other three alternatives. When this happens a) it either occurs quickly in countries that don't have reserve currencies, that have significant foreign currency denominated debts and in which the inflation rate is measured in their rapidly depreciating local currency, and b) it can occur slowly and late in the deleveraging process of reserve currency countries, after a long time and a lot of stimulation that is used to reverse a deflationary deleveraging.
Phase 4) Transfer of wealth: This takes place in many forms (e.g., increased taxes on the wealthy, financial support programs such as those the "rich" European countries are providing to the overly indebted ones, etc.) throughout the process, but they rarely occur in amounts that contribute meaningfully to the deleveraging (unless there are "revolutions").
Investment Options: Now lets us turn our focus to Ray Dalio's major portfolio holdings.
Ray Dalio is long on gold (GLD) due to expected low growth in the United States and Europe for at least the next decade. The firms co-chief investment officer Robert Prince, stated in the WSJ Article titled "Bridgewater Takes Grim View of 2012":
We're (US) in a secular deleveraging that will probably take 15 to 20 years to work through, and we're just four years in.
The Fed would opt for a low interest rate environment with US having to undergo pending years of low-growth deleveraging ahead. It would also resort to buying Treasuries, inflating its asset prices as well. Further, Ray Dalio's strength lies in macro investing and uses ETFs to gain broad exposure to the stock market or to hedge his other bets.
We will now look at some of the ETF he holds as a hedge. According to Insider monkey, Ray Dalio has 42% of its portfolio invested in SPDR S&P 500 Trust ETF (SPY). His other top ETF holdings include Vanguard Emerging Markets Stock ETF (VWO), iShares MSCI Emerging Markets Index ETF (EEM), Market Vectors Gold Miners ETF (GDX) and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
Investors can take exposure to Gold using the following ETFs as well.